Thursday, March 26, 2009

"Fad diets are popular because they promise amazing results with minimal effort. Many people want to lose weight but are not eager to pay the price of eating fewer calories and exercising more regularly. These people are convinced all too easily by the reassuring words of some self-proclaimed expert selling a miraculous product. The want to believe that this new, easy-to-follow diet really will work.

"Fad economics is also popular, for much the same reason. Anyone can adopt the title 'economist' and claim discovery of some easy fix to the economy's troubles. These fads often tempt politicians, who are eager to find easy and novel solutions to hard and persistent problems. Some fads come from charlatans who use crazy theories to gain the limelight and promote their own interests. Others come from cranks who believe that their theories really are true.

"An example of fad economics occurred in 1980, when a small group of economists advised presidential candidate Ronald Reagan that an across-the-board cut in income tax rates would raise tax revenue. They argued that if people could keep a higher fraction of their income, people would work harder to earn more income. Even though tax rates would be lower, income would rise by so much, they claimed, that tax revenue would rise. Almost all professional economists, including most of those who supported Reagan's proposal to cut taxes, viewed this outcome as far too optimistic. Lower tax rates might encourage people to work harder, and this extra effort would offset the direct effects of lower tax rates to some extent. But there was no credible evidence that work effort would rise by enough to cause tax revenues to rise in the face of lower tax rates. George Bush, also a presidential candidate in 1980, agreed with most of the professional economists: He called this idea 'voodoo economics.' Nonetheless, the argument was appealing to Reagan, and it shaped the 1980 presidential campaign and the economic policies of the 1980s.

"People on fad diets put their health at risk but rarely achieve the permanent weight loss they desire. Similarly, when politicians rely on the advice of charlatans and cranks, they rarely get the desirable results they anticipate. After Reagan's election, Congress passed the cut in tax rates that Reagan advocated, but the tax cut did not cause tax revenue to rise. Instead, tax revenue fell, as most economists predicted it would, and the U.S. federal government began a long period of deficit spending, leading to the largest peacetime increase in the government debt in history.

"Fads can make the experts seem less united than they actually are. It would be wrong to conclude that professional nutritionists are in disarray simply because fad diets are so popular. In fact, nutritionists have agreed on the basics of weight loss - exercise and a balanced low-fat diet - for many years. Similarly, when the economics profession appears in disarray, you should ask whether the disagreement is real or manufactured. It may be that some snake-oil salesman is trying to sell a miracle cure for what ails the economy."

IF you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

The economy’s output of goods and services is traditionally divided into four components: consumption, investment, net exports and government purchases. Any expansion in demand has to come from one of these four. But in each case, strong forces are working to keep spending down.

CONSUMPTION The Conference Board reports that consumer confidence is near its record low. It is easy to understand why consumers are so scared. House values have declined, 401(k) balances have shrunk and unemployment is up. For many people, the sense of economic uncertainty is greater than they’ve ever experienced. When it comes to discretionary purchases, like a new home, a car, or a washing machine, wait-and-see is the most rational course.

A bit more saving is not entirely unwelcome. Many economists have long lamented the United States saving rate, which is low by international and historical standards.

For the overall economy, however, a recession is not the best time for households to start saving. Keynesian theory suggests a “paradox of thrift.” If all households try to save more, a short-run result could be lower aggregate demand and thus lower national income. Reduced incomes, in turn, could prevent households from reaching their new saving goals.

INVESTMENT In normal times, a fall in consumption could be met by an increase in investment, which includes spending by businesses on plant and equipment and by households on new homes. But several factors are keeping investment spending at bay.

The most obvious is the state of the housing market. Over the past three years, residential investment has fallen 42 percent. With house prices continuing to decline, increased building of new homes is not likely to be a source of robust demand over the next few years.

Business investment has lately been stronger than residential investment, but it is unlikely to pick up the slack in the near future. With the stock market down, interest rates on corporate bonds up and the banking system teetering on the edge, financing new business projects will not be easy.

NET EXPORTS Not long ago, it looked as if the rest of the world would save the United States economy from a deep downturn. From March 2004 to March 2008, the dollar fell 19 percent against an average of other major currencies. By increasing the price of foreign goods in the United States and reducing the price of American goods abroad, this depreciation discouraged imports and bolstered exports. Over the last three years, real net exports have increased by about $250 billion.

In the coming months, however, the situation may well go into reverse. As the United States financial crisis has spread to the rest of the world, fast-moving international capital has been looking for a safe haven. Ironically, that haven is the United States. Since March, the dollar has appreciated 19 percent, a move that will put a crimp in the export boom.

GOVERNMENT PURCHASES That leaves the government as the demander of last resort. Calls for increased infrastructure spending fit well with Keynesian theory. In principle, every dollar spent by the government could cause national income to increase by more than a dollar if it leads to a more vibrant economy and stimulates spending by consumers and companies. By all reports, that is precisely the plan that the incoming Obama administration has in mind.

The fly in the ointment — or perhaps it is more an elephant — is the long-term fiscal picture. Increased government spending may be a good short-run fix, but it would add to the budget deficit. The baby boomers are now starting to retire and claim Social Security and Medicare benefits. Any increase in the national debt will make fulfilling those unfunded promises harder in coming years.

Keynesian economists often dismiss these long-run concerns when the economy has short-run problems. “In the long run we are all dead,” Keynes famously quipped.

The longer-term problem we now face, however, may be more serious than any that Keynes ever envisioned. Passing a larger national debt to the next generation may look attractive to those without children. (Keynes himself was childless.) But the rest of us cannot feel much comfort knowing that, in the long run, when we are dead, our children and grandchildren will be dealing with our fiscal legacy.

So what is to be done? Many economists still hope the Federal Reserve will save the day.

In normal times, the Fed can bolster aggregate demand by reducing interest rates. Lower interest rates encourage households and companies to borrow and spend. They also bolster equity values and, by encouraging international capital to look elsewhere, reduce the value of the dollar in foreign-exchange markets. Spending on consumption, investment and net exports all increase.

But these are not normal times. The Fed has already cut the federal funds rate to 1 percent, close to its lower bound of zero. Some fear that our central bank is almost out of ammunition.

Fortunately, the Fed has a few secret weapons. It can set a target for longer-term interest rates. It can commit itself to keeping interest rates low for a sustained period. Most important, it can try to manage expectations and assure markets that it will do whatever it takes to avoid prolonged deflation. The Fed’s decision last week to start buying mortgage debt shows its willingness to act creatively.

It is hard to say how successful monetary and fiscal policy will be in avoiding a deep downturn. But as events unfold, you can be sure that policymakers in the Fed and Treasury will be looking at them through a Keynesian lens.

In 1936, Keynes wrote, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist.” In 2008, no defunct economist is more prominent than Keynes himself.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President Bush and advised Mitt Romney in his campaign for the Republican presidential nomination.

"Our enormously productive economy... demands that we make consumption our way of life, that we convert the buying and use of goods into rituals, that we seek our spiritual satisfaction, our ego satisfaction, in consumption... we need things consumed, burned up, replaced and discarded at an ever-accelerating rate.""Price Competition in 1955", Victor Lebow". 2008-07-28. http://www.scribd.com/doc/965920/LebowArticle.

"... more than 50% of our [ U.S. ] federal tax money is now going to the military, ...""Of the 100 largest economies on earth now, 51 are corporations.""We [The U.S.] has 5% of the world’s population but we’re consuming 30% of the world’s resources and creating 30% of the world’s waste.""80% of the planet’s original forests are gone.""In the Amazon alone, we’re losing 2000 trees a minute.""Each of us in the U.S. is targeted with more than 3,000 advertisements a day.""Each of us in the United States makes 4 1/2 pounds [2.04 kg] of garbage a day.""Dioxin is the most toxic man made substance known to science. And incinerators are the number one source of dioxin."

Systems of allocation are typically based on two criteria:(1) efficiency (Is society obtaining the most products from its resources?)(2) equity (Is the distribution of products fair?)

People frequently disagree about what is fair.

Markets are very efficient. Thus many people profess the desirability of “free markets” and “free trade.” (Business leaders, especially favor reducing or eliminating government regulation of markets, because regulation tend to reduce profits. Profit is revenues minus expenses.)

But when markets are allowed to operate freely, they produce some socially undesirable outcomes. (Markets are selfish and mean.)

Markets create too much of some things (pollution, poverty, and market power) and too little of other things [national defense, police and fire protection, education (schools and libraries), public health and disease prevention, roads and highways, etc.]

Consequently, we choose to have the government tax us and use the revenues to provide government services. (Government is not evil.)

Pollution in the St. John´s River in Jacksonville, Florida.Pollution in the Cuyahoga River in Cleveland, Ohio.

If a society wants to have more goods and services, it needs to acquire more resources or become more efficient in their allocation. Markets tend to be more efficient at the allocation of resources than the government or tradition systems. Yet, markets are not perfect. There are many market failures in which the market does not provide the socially desirable outcome. Free markets create too much Free (i.e., unregulated) markets create too little capital. Consequently, most people agree government is needed to provide things that

The Economics of Conservatives and LiberalsFrom a forthcoming book by Dr. John B. Buck entitled Understanding Macroeconomics.

Traditional conservatives believe government, and thus taxes, should be relatively small. They also tend to think it is fair for the tax burden to be distributed more broadly across people of various incomes than liberals do. They justify this belief by focusing on the progressivity[1] of individual income tax rates. Conservatives tend to believe either that market failures[2] are relatively small or that the government is ineffective at correcting them. Both are justifications for small government. Conservatives favor smaller government welfare programs and less redistribution of income. Thus, critics of traditional conservatives claim they are less concerned with issues of equity or fairness than liberals. Conservatives respond that people already have relatively equal opportunities (e.g., everyone has access to public education) or that it is not the government’s role to provide such opportunities. Conservatives point out that the waste and abuse of the welfare system is both inefficient and unfair. Conservatives are sometimes accused of being selfish and inconsiderate of others in society. However, wealthy Americans engage in a myriad of charitable activities and donate vast amounts of wealth to agencies that benefit others. They argue that private organizations tend to be more efficient at providing assistance to those in need than the government.

Traditional liberals believe government, and thus taxes, should be relatively large. Most liberals think it is fair for the tax burden to be borne primarily by the rich. They justify this belief using a philosophy known as the ability-to-pay principle.[3] Liberals claim conservatives ignore the regressivity[4] of social insurance and sales taxes and that tax breaks and shelters provide the most benefits to the wealthy. They also point out that middle and lower-income families already pay a larger share of taxes than they are given credit for[5] and argue the total tax burden is already relatively proportional. Liberals tend to believe that market failures are relatively large, that the government is fairly effective at correcting them, or that issues of fairness are more important than economic efficiency. Liberals are accused of being selfish when they want government benefits to be paid by other taxpayers. Critics of traditional liberals claim they lack sufficient concern for economic efficiency and have an exaggerated sense of fairness. Liberals are often accused of recklessly and wastefully spending other people’s money and promoting handouts that undermine the incentive to work. Liberals tend to think Americans do not have equal opportunities or that some citizens suffer from past inequities. Thus, they are more likely than conservatives to favor affirmative action programs or similar projects.

Compassionate conservatism is the phrase used by President George W. Bush to describe his belief in bigger government and lower taxes. Compassionate conservatives argue either that lower taxes will lead to such dramatic economic growth that future tax revenues will be sufficient to pay for today’s government spending and future government expenses, or they argue that deficits and government debt do not matter and debts can be passed to future generations without the need to ever be paid. Traditional conservatives and most economists think compassionate conservatives use flawed logic.[6] Budget deficits and increasing public debt place higher demands on government revenues in the form of interest payments to those who have loaned money to the government. While these may be tolerable in the short-run, they have the potential to be crippling to the U.S. economy when interest rates rise and the baby-boom generation progresses from being a significant source of revenue for the government[7] to being a significant expense[8].

[1] With a progressive tax, people with higher incomes pay a higher percentage of their income than people with lower incomes. The structure of the U.S. individual income tax system is progressive because high-income people face a higher marginal tax rate than those with lower incomes. This is often referred to as being in a higher tax bracket.[2] Market failures occur when the market system fails to provide the socially desirable outcome. If the market system is left completely alone, it creates too much of some things (e.g., pollution, poverty, and market power) and not enough of other things (e.g., national defense, education, and basic research).[3] The ability-to-pay principle states that taxes should be paid by those who are best able to pay them. A contrasting idea, the benefits principle, states that taxes should be paid by those who receive the benefits from the services provided by the government. Both principles are used in the U.S. tax structure. Fuel taxes are designed to generate revenue for the construction and maintenance of highways and roads. Since the people who use the highways and roads the most also buy the most fuel, fuel taxes are based on the benefits principle. Since welfare programs redistribute income, they cannot be based on the benefits principle. The people who receive the transfers of income cannot also pay for them. [4] With a regressive tax, people with lower incomes pay a higher percentage of their income than people with higher incomes. Payroll taxes for Social Security and Medicare, often referred to as social insurance taxes, are regressive because high-income people pay these taxes on only a portion of their income while low-income people pay these taxes on all of their income. Sales taxes are also regressive because they are a represent a higher percentage of income for the poor than for the rich.[5] Individual income taxes provide about 50% of the federal government’s revenues. Payroll taxes provide about 35% of the federal government’s revenues.[6] Wishful thinking is probably part of it, too.[7] Workers tend to earn the most income, and thus pay the most tax revenue, in the years just prior to retirement.[8] Baby-boomers will add significantly to the Social Security and Medicare expenses of the federal government.

There are two flaws in this critique of Obama, which is coming from someone who I presume would be criticizing him regardless of the performance of the stock market or the economy. The editorial is yet another example of the post hoc ergo propter hoc flaw of logic that is all too common in political and economic discourse. For the sake of expedience, allow me to quote the Wikipedia entry:

Post hoc ergo propter hoc, Latin for "after this, therefore because (on account) of this", is a logical fallacy (of the questionable cause variety) which states, "Since that event followed this one, that event must have been caused by this one." It is often shortened to simply post hoc and is also sometimes referred to as false cause, coincidental correlation or correlation not causation. It is subtly different from the fallacy cum hoc ergo propter hoc, in which the chronological ordering of a correlation is insignificant.Post hoc is a particularly tempting error because temporal sequence appears to be integral to causality. The fallacy lies in coming to a conclusion based solely on the order of events, rather than taking into account other factors that might rule out the connection. Most familiarly, many superstitious beliefs and magical thinking arise from this fallacy.

The form of the post hoc fallacy can be expressed as follows:A occurred, then B occurred.Therefore, A caused B.When B is undesirable, this pattern is often extended in reverse: Avoiding A will prevent B.

From Attacking Faulty Reasoning by T. Edward Damer:[1]“I can't help but think that you are the cause of this problem; we never had any problem with the furnace until you moved into the apartment." The manager of the apartment house, on no stated grounds other than the temporal priority of the new tenant's occupancy, has assumed that the tenant's presence has some causal relationship to the furnace's becoming faulty.”From With Good Reason by S. Morris Engel:[2]“More and more young people are attending high schools and colleges today than ever before. Yet there is more juvenile delinquency and more alienation among the young. This makes it clear that these young people are being corrupted by their education.

The decline of stock markets since Obama took office is not proof that his policies caused the decline nor that his policies are not the appropriate ones to improve the economy. The Dow Jones Industrial Average (DJIA) closed at 14,164.53 on October 9, 2007. On Election Day, November 4, 2008, the DJIA closed at 9,625.28. On January 20, 2009, the day of President Obama’s inauguration, the DJIA closed at 7,949.09. The stock markets were in decline long before Obama was elected or took office. The decline in the Dow since Obama became President is (7949 – 6763)/7949 = 0.149 or about 15%. The author picked an arbitrary date in January to imply a bigger decline. The decline in the Dow before Obama became President was (14164 – 7949)/14164 = .438 or about 44%. So if one wanted to usepost hoc ergo propter hoc (and remember one shouldn’t), a more reasonable conclusion is that the last 15 months of President Bush’s policies were much more damaging to Wall Street than Obama’s have been.

Another flaw in this editorial is the presumption that whatever is good for stock markets is good for the economy. I agree that health-care stocks have declined because of Obama’s plans to save taxpayers money by reining in rapidly rising medical costs. But that does not prove that Obama’s policies are detrimental to the economy as a whole. Consider the opposite. If Obama announced that he would give trillion dollar gifts to all the corporations in the Dow Jones Industrial Average for no use other than to make them more profitable, the stocks of the benefitting companies would undoubtedly rise. But such a policy would add tremendously to the public debt burden of future generations without doing anything to increase the productivity of the economy or improve its long-term health. It is a mistake to assume that anything that benefits the wealthy or business interests (such as tax cuts and deregulation) is necessarily good for the economy. Some increases or decreases in taxes and government regulation of business may be beneficial to society as a whole. Others are not.

The author is critical of the income transfers in the stimulus package, preferring spending on public works. But the fundamental cause of this recession is insufficient overall spending on newly produced goods and services. The logic behind the income transfers is that they are a quick way to inject purchasing power into the hands of those most likely to spend. The biggest downside of income transfers is that the money might not be spent on newly made U.S. products. It could be used to pay down credit card debt or to buy foreign-made products, such as the many Chinese goods at Wal-Mart. If the government spends the money directly, such as on infrastructure projects, it can ensure the money goes to U.S. companies with American workers. And there is a lasting benefit from public works spending because the new highways, repaired bridges, and more energy efficient government buildings will continue to provide benefits for many years to come. The largest downside of public works spending is that these projects can take a long time to complete and the economy needs the increased spending immediately. Indeed, the best criticism of the stimulus package is that by the time some of its spending occurs, the recession might be over. (Then again, it might not.)

The criticism that the tax cuts are “devoted to income maintenance rather than to improving incentives to work or invest,” is a gilded way to assert that they should have been given to rich people and wealthy corporations rather than to low and middle-income Americans. By preserving incomes with tax reductions, the government is trying to maintain the purchasing power of the overall economy and prevent the recession from worsening. Tax policy can be used to alter society’s behavior, such as to encourage research and development or investment in physical capital. But those effects kick in much later than the immediate impact of income maintenance. And many of the tax cuts advocated by the rich are not structured to have targeted benefits to the economy. And I have always had difficulty with the theoretical argument that tax cuts increase the incentive to work. Everyone I know with a 9 to 5 job works 40 hours per week regardless of which tax bracket they are in. I have never had anyone tell me he or she works more or less because of changes in tax rates.

Anyone who has taken a class from me should know I am a huge advocate of markets and capitalism. But it is not a blind or ideological devotion. Capitalism and the markets it creates have a potentially destructive aspect. Unregulated markets can cause massive damage to society. (In the absence of government regulation, the market system allowed so much pollution into the environment that in 1969 the Cuyahoga River in Cleveland, Ohio literally caught on fire.) The important question is the appropriate degree of regulation. In a capitalist system, banks, like other profit-seeking businesses, should be allowed to fail. Yet, banks play a much different role in our economy than other businesses. The ability to borrow money does facilitate the overall spending that maintains our economy. And it is the inability to borrow and a lack of confidence in the financial sector that are critical components of our current economic troubles. Most financial experts believe failing to prop up these financial institutions would be devastating to our economy. Indeed, a common criticism of the handling of the financial crisis by President George W. Bush’s Secretary of the Treasury, Hank Paulson, is that he allowed the Lehman Brothers financial services company to go bankrupt, worsening the meltdown. In the absence of sufficient government regulation, banks became too large, too intertwined, and were allowed to engage in activities with too much risk. I believe the biggest mistake was to allow individual banks to become “too big to fail.” If government regulation had prevented much of the consolidation in the banking industry and had maintained a financial system with numerous smaller banks, it would be much easier to forego bailouts and let the worst ones fail.

What is a recession and how does it differ from a depression?A recession is a sustained decrease in economic activity that is typically accompanied by decreases in employment, national income, and the production of goods and services. An unofficial way to estimate the existence a recession is to look for at least two consecutive quarters of declines in gross domestic product (GDP). The official calculations are more complex and are conducted by the National Bureau of Economic Research (NBER).A depression is a severe and prolonged recession.

What causes recessions and depressions?Recessions and depressions are caused by insufficient overall spending on newly produced goods and services. When there is insufficient aggregate demand (AD) for new products, stores sell fewer things, causing factories to produce less output and increasing unemployment. As workers lose their jobs, their incomes are reduced, leading to further decreases in overall spending and deepening the economic downturn.The recession that began in December 2007 was caused by collapsing housing prices, the subprime mortgage crisis, and subsequent tightening of credit markets. In 2004 and 2005, the United States experienced unusually rapid increases in housing prices, sometimes referred to as a real estate bubble. Low interest rates and insufficiently regulated lending practices fueled these unsustainable price increases. Many people increased general purchases by borrowing against their homes (with unrealistically high values). Housing prices peaked in 2006 and the subsequent declines, sometimes called the bursting of the bubble, triggered home foreclosures, the subprime mortgage crisis and reductions in loans. Thus, real estate declines led to a decrease in the aggregate demand (AD) for newly produced goods and services.

Should the government do anything to prevent further economic declines?Economic declines will eventually end without government intervention, but it may take an unacceptably long period of time. The British economist John Maynard Keynes popularized the idea that the government should play an active role in managing the economy. Keynes admitted that an unassisted economy may correct itself in the long run, but “in the long run we are all dead.” We may not live long enough to see the improvement in the economy. Recessions are caused by insufficient overall spending on newly produced goods and services. Increases in unemployment reduce national income, which in turn reduces aggregate demand further. This deepens the economic decline and may lead to a depression. The length and severity of the Great Depression led most economists and public policy analysts to conclude that it is appropriate for the government to intervene in the economy to try to reduce the severity of recessions and prevent depressions.

What types of government policies reduce the severity of recessions and reverse economic declines?The government has two broad options for managing the overall economy: monetary policy and fiscal policy. In the United States, expansionary monetary policy is the Federal Reserve system´s use of the money supply, interest rates, and the banking system to encourage commercial banks to lend more money to the public in the hope that this will increase overall spending on newly produced U.S. goods and services. The collapse of credit markets in 2008 reduced most types of lending and will require a restoration of confidence (perhaps by improved oversight and regulation) before monetary policy can assist in economy recovery (by lending more money to encourage more overall spending).Fiscal policy is taxation and government spending. The logic of using tax cuts to counter a recession is that if the government takes less money from individuals and businesses, they will have more money to spend. Remember the cause of the U.S. economic downturn is insufficient overall spending on newly produced American goods and services. In this regard, tax cuts are essentially identical to the federal government handing out money. The goal is to put more money in the hands of individuals and businesses in the hope that they will spend it on products that are newly made by U.S. workers. Many debates about tax cuts are essentially decisions about to whom the government should be giving money. Tax cuts and other increases in government handouts are relatively quick ways to inject purchasing power into the economy and increase the potential for increases in aggregate demand. There is no way to guarantee that these income supplements will result in purchases of newly made U.S. products, however. For example, much of the increased disposable income caused by the tax cuts of 2001 and 2003 resulted in paying down consumer debt rather than increased consumer spending. And even when spent, if the products purchased are not American-made there is limited benefit to the U.S. economy and its workers. Even though tax cuts or other government handouts can be done quickly, they may be poor choices if they do not significantly increase overall spending on newly produced U.S. goods and services.An alternative fiscal policy to counteract economic declines is an increase in government purchases. The primary benefit of this choice is that government procurement policies can ensure that this increased spending goes to U.S. businesses that employ American workers. A difficulty with this approach, however, is that it may be difficult to spend sufficient quantities of money quickly enough on projects of long-term benefit. Infrastructure projects can take long periods of time to complete and thus may not inject additional income into the economy quickly enough. Similar arguments can be made for proposals to improve energy efficiency, develop alternative fuel sources, or reform the health care industry. Projects that can be quickly implemented, however, may be of questionable long-term benefit. Yet, if the result is increased purchases of new products made by U.S. workers and suppliers, they still may be preferable to tax cuts (if the tax cuts are used to pay down debt or buy used or foreign products).Tax cuts and increases in government spending both increase budget deficits and the national debt. Criticisms of stimulus proposals on the basis of reluctance to increase public borrowing apply equally to tax reductions and increased spending programs. Running deficits is not always bad, however. For example, many students borrow substantial sums of money in order to attend college. This indebtedness is easily justified, however, because it leads to a college degree that increases earnings potential for the remainder of one´s career. Similarly, it can be reasonable for a society to borrow money from future generations if the funds are spent wisely on things that increase the productive ability of the economy and improve future living standards. Future generations may not mind if money is borrowed from them to develop alternative energy sources that result in less environmental degradation. It is less arguable to accumulate massive public debt based on willful ignorance, selfishness, or simple reluctance to pay one´s way. The 2001 and 2003 tax cuts were the first wartime tax decreases in U.S. history. Previous generations were willing to make sacrifices for causes they believed in. Tax decreases are popular and are undoubtedly of short-term benefit to those allowed to pay less in tax. The dramatic increases in U.S. budget deficits and public debt since 1980 have been of great short-term benefit to many sectors of the economy. But they have done substantial harm to the long-term benefit of the U.S. and global economies (for many of the reasons cited by critics of current stimulus proposals). It is akin to allowing large numbers of people to go to the mall, stuff shopping bags with items, and walk out without paying. It is of great short-term benefit to those who get away with it. But these strategies are not sustainable in the long-term. Selfish and misguided choices over the previous three decades have left American policymakers with few, if any, desirable options. The more important question may be how long will it take before U.S. citizens become willing to make the sacrifices and tough choices necessary to correct the abuses of the past and demand more honest, reasoned leadership.

What about the supply-side argument that tax cuts induce businesses to increase investment and create jobs?A business does not need a tax cut to create a job. A rational business manager will hire a worker if that person generates more additional income than what he or she is paid in wages, salary, and benefits. Similarly, business investment will occur if the perceived future revenues exceed the expected costs. Subsides can be used to increase private investment in factories or equipment. But they may be of no more benefit than similar expenditures by government entities. Any increases in physical capital can be of future benefit to the economy, whether in the form of government subsidies to private businesses or direct government purchases for public investment.Factory workers do not lose their jobs because of the lack of a factory, as supply-side theorists might suggest. It is insufficient demand for their products that causes the job losses.

In "The Trouble with Obama´s New Deal," an editorial published in the March 12, 2009 edition of TIME magazine, former House Speaker Newt Gingrich argues "the policies of this Administration and the Democratic Congress are making it difficult to stabilize the stock market and much harder to get successful people to invest in American jobs." Yet, contrary to what Gingrich would have you believe, the problem is not that we have not been insufficiently generous to businesses or excessive in regulation of them. Recessions are caused by insufficient overall spending in the economy.

In "The Dogfight Over Economic Stimulus", Business Week´s Peter Coy suggests "economists can´t decide whether massive stimulus will help - or drive America further down." However, the disagreement is much more a matter of politics than economics.

Dick Armey, the former majority leader of the House of Representatives, provided a scathing critique of Keynesian economics in an editorial published in the Wall Street Journal on February 4, 2009. In "Washington Could Use Less Keynes and More Hayek," Armey cites the two Nobel Prize winning economists who would oppose the current efforts to reverse the economic downturn and ignores all the other Nobel laureates who are firm advocates of Keynesianism.

Wednesday, March 25, 2009

"All of the federal government´s efforts to stem the tide of the financial meltdown have added hundreds of billions of dollars to an already staggering national debt, a sum that is expected to double over the next 10 years to more than $23 trillion. In Ten Trillion and Counting, FRONTLINE traces the politics behind this mounting debt and investigates what some say is a looming crisis that makes the current financial situation pale in comparison."

What do we know about the spread of protectionism during the Great Depression and what are the implications for today’s crisis? This column says the lesson is that countries should coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could once again be most unfortunate.

The Great Depression of the 1930s was marked by a severe outbreak of protectionism. Many fear that, unless policymakers are on guard, protectionist pressures could once again spin out of control. What do we know about the spread of protectionism then, and what are the implications for today?

While many aspects of the Great Depression continue to be debated, there is all-but-universal agreement that the adoption of restrictive trade policies was destructive and counterproductive and that similarly succumbing to protectionism in our current slump should be avoided at all cost. Lacking other instruments with which to support economic activity, governments erected tariff and nontariff barriers to trade in a desperate effort to direct spending to merchandise produced at home rather than abroad. But with other governments responding in kind, the distribution of demand across countries remained unchanged at the end of this round of global tariff hikes. The main effect was to destroy trade which, despite the economic recovery in most countries after 1933, failed to reach its 1929 peak, as measured by volume, by the end of the decade (Figure 1). The benefits of comparative advantage were lost. Recrimination over beggar-thy-neighbour trade policies made it more difficult to agree on other measures to halt the slump.

Figure 1. World trade and production, 1926-1938

The impression one gleans from both contemporary and modern accounts is that trade policy was thrown into complete chaos, with every country scrambling to impose higher barriers. But, in fact, this was not exactly the case (Eichengreen and Irwin, forthcoming). Although recourse to trade restrictions was widespread, there was considerable variation in how far countries moved in this direction. Figure 2 illustrates this for tariffs. Tariff rates rose sharply in some countries but not others. The history of the 1930s would have been very different had other countries responded in the manner of, say, Denmark, Sweden and Japan. It is important to understand why they did not.

Figure 2. Average tariff on imports, 1928-1938, percentage

The answer, in a nutshell, is the exchange rate regime and the policies associated with it. Countries that remained on the gold standard, keeping their currencies fixed against gold, were more inclined to impose trade restrictions. With other countries devaluing and gaining competitiveness at their expense, they adopted restrictive policies to strengthen the balance of payments and fend off gold losses. Lacking other instruments with which to address the deepening slump, they used tariffs and similar measures to shift demand toward domestic production and thereby stem the rise in unemployment.

In contrast, countries abandoning the gold standard and allowing their currencies to depreciate saw their balances of payments strengthen. They gained gold rather than losing it. As importantly, they now had other instruments with which to address the unemployment problem. Cutting the currency loose from gold freed up monetary policy. Without a gold parity to defend, interest rates could be cut, and central banks No longer bound by the gold standard rules could act as lenders of last resort. They now possessed other tools with which to ameliorate the Depression. These worked, as shown in Figure 3. As a result, governments were not forced to resort to trade protection.

Figure 3. Change in industrial production, by country group

This relationship is quite general, as we show in Figure 4. It also carries over to non-tariff barriers to trade such as exchange controls and import quotas.

This finding has important implications for policy makers responding to the Great Recession of 2009. The message for today would appear to be “to avoid protectionism, stimulate.” But how? In the 1930s, stimulus meant monetary stimulus. The case for fiscal stimulus was neither well understood nor generally accepted. Monetary stimulus benefited the initiating country but had a negative impact on its trading partners, as shown by Eichengreen and Sachs (1985). The positive impact on its neighbours of the faster growth induced by the shift to “cheap money” was dominated by the negative impact of the tendency for its currency to depreciate when it cut interest rates. Thus, stimulus in one country increased the pressure for its neighbours to respond in protectionist fashion.

Today the problem is different because the policy instruments are different. In addition to monetary stimulus, countries are applying fiscal stimulus to counter the Great Recession. Fiscal stimulus in one country benefits its neighbours as well. The direct impact through faster growth and more import demand is positive, while the indirect impact via upward pressure on world interest rates that crowd out investment at home and abroad is negligible under current conditions. When a country applies fiscal stimulus, other countries are able to export more to it, so they have no reason to respond in a protectionist fashion.

The problem, to the contrary, is that the country applying the stimulus worries that benefits will spill out to its free-riding neighbours. Fiscal stimulus is not costless – it means incurring public debt that will have to be serviced by the children and grandchildren of the citizens of the country initiating the policy. Insofar as more spending includes more spending on imports, there is the temptation for that country to resort to “Buy America” provisions and their foreign equivalents. The protectionist danger is still there, in other words but, insofar as the policy response to this slump is fiscal rather than just monetary, it is the active country, not the passive one, that is subject to the temptation.

But if the details of the problem are different, the solution is the same. Now, as in the 1930s, countries need to coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could again be most unfortunate.

References

Barry Eichengreen and Douglas A. Irwin (2009), “The Great Depression and the Protectionist Temptation: Who Succumbed and Why?” (forthcoming).

Barry Eichengreen and Jeffrey Sachs (1985), “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History 45, 925-946.

WASHINGTON - As the Bush administration was drawing to a close, Robert M. Gates, whose two years as defense secretary had been devoted to wars in Iraq and Afghanistan, felt compelled to warn his successor of a crisis closer to home.

The United States "cannot expect to eliminate national security risks through higher defense budgets, to do everything and buy everything," Gates said. The next defense secretary, he warned, would have to eliminate some costly hardware and invest in new tools for fighting insurgents.

What Gates didn't know was that he would be that successor.

Now, as the only Bush Cabinet member to remain under President Obama, Gates is preparing the most far-reaching changes in the Pentagon's weapons portfolio since the end of the Cold War, according to aides.

Two defense officials who were not authorized to speak publicly said Gates will announce up to a half-dozen major weapons cancellations later this month. Candidates include a new Navy destroyer, the Air Force's F-22 fighter jet, and Army ground-combat vehicles, the offi cials said.

More cuts are planned for later this year after a review that could lead to reductions in programs such as aircraft carriers and nuclear arms, the officials said.

As a former CIA director with strong Republican credentials, Gates is prepared to use his credibility to help Obama overcome the expected outcry from conservatives. And after a lifetime in the national security arena, working in eight administrations, the 65-year-old Gates is also ready to counter the defense companies and throngs of retired generals and other lobbyists who are gearing up to protect their pet projects.

"He has earned a great deal of credibility over the past two years, both inside and outside the Pentagon, and now he is prepared to use it to lead the department in a new direction and bring about the changes he believes are necessary to protect the nation's security," said Geoff Morrell, the Pentagon press secretary.

Gates is not the first secretary to try to change military priorities. His predecessor, Donald H. Rumsfeld, sought to retool the military but succeeded in cancelling only one major project, an Army artillery system.

Former vice president Dick Cheney's efforts as defense chief under the first President Bush, meanwhile, are cited as a case study in the resistance of the military, defense industry, and Capitol Hill. Cheney canceled the Marine Corps' troubled V-22 Osprey aircraft not once, but four times, only to see Congress reverse the decision.

"There are so many people employed in the industry and they are spread across the country," William S. Cohen, former Republican senator from Maine who was Defense secretary in the Clinton administration, said in an interview. "Even though members of Congress may say, 'It's great that you are recommending the termination of X, Y, and Z,' they will also say 'that means 4,000 jobs in my state. Frankly, I can't go along with that.' "

Major weapons cuts could be an even tougher sell now, he added. "When you start talking about an economy that is in a state of considerable turmoil it becomes even more difficult," Cohen said.

Yet even some of the Pentagon's fiercest critics, such as Winslow Wheeler of the liberal Center for Defense Information, believe the Obama administration may have a unique opportunity with Gates at the helm.

Wheeler, a former Capitol Hill defense aide, noted that Gates has shown a unique toughness, including removing the Army secretary and the civilian and military heads of the Air Force for lapses on their watch.

"That demonstrates there is a spine there," said Wheeler.

Such dramatic moves were easier for Gates because he spent much of his career as an intelligence analyst warning about the threats of Soviet Communism. Now, as a Cold War veteran in an administration perceived to be lacking in defense experience, he is perhaps the only person capable of pushing through big cutbacks.

"He obviously has huge credibility as something of a hawk," said James Shinn, who worked for Gates as assistant Defense secretary in the Bush administration. "No one can even remotely challenge Gates in terms of his well-informed and conservative approach toward threats and the weapon systems associated with threats."

In between briefing books and intelligence assessments, Gates recently read "Agincourt," a novel about the medieval battle in which the British Army routed a much larger French force with a new weapon, the longbow, that was able to penetrate French armor. A turning point in the Hundred Years War, in 1415, the battle could serve as an analogy for the changes Gates believes are necessary to pursue terrorists.

Today's security threats, Gates believes, are far different from when, during his first week on the job as a CIA analyst in 1968, the Soviet Army invaded Czechoslovakia.

"Let's be honest with ourselves," Gates told the National Defense University last September. "The most likely catastrophic threats to our homeland - for example, an American city poisoned or reduced to rubble by a terrorist attack - are more likely to emanate from failed states than from aggressor states."

Gates has said it would be "irresponsible" not to plan for the possibility that another nation could threaten US military dominance, but he pointed out that the US Navy is larger than the next 13 navies combined, 11 of which are American allies.

"US air and sea forces have ample untapped striking power should the need arise to deter or punish aggression - whether on the Korean Peninsula, in the Persian Gulf, or across the Taiwan Strait," he wrote in the latest issue of Foreign Affairs magazine.

As for fears of a resurgent Russia, Gates said, "As someone who used to prepare estimates of Soviet military strength for several presidents, I can say that Russia's conventional military, although vastly improved since its nadir in the late 1990s, remains a shadow of its Soviet predecessor."

Gates's budget plans remain closely guarded, but aides say his decisions will be guided by the time he has spent with soldiers in Iraq and Afghanistan.

One aide who has traveled with Gates more than a dozen times said the secretary "is particularly keen and aware of the urgent operational needs on the ground."

That likely means greater investments in intelligence-gathering systems such as pilotless drone aircraft, special-operations forces and equipment, and advanced cultural training for military personnel, aides said.

Girding for a showdown with Congress, Gates took the unusual step of making the Joint Chiefs of Staff and other participants in budget deliberations sign nondisclosure agreements to prevent leaks.

But already lawmakers and defense contractors are preparing to fight back. Lockheed, maker of the F-22 jet, recently launched an ad campaign to protect its fighter. Northrop Grumman, which could face cutbacks to its ship-building programs, has hired consultants to write op-eds. Unions are raising alarms about job losses.

Even his closest friends acknowledge Gates is in the bureacratic fight of his life.

"He is going to have a hard time," said former US national security adviser and retired Air Force Lieutenant General Brent Scowcroft, who is considered Gates's mentor and speaks to his protoge frequently. "The resistance in the system is heavy. But that what Bob is trying to take on."

Thursday, March 5, 2009

The Wall Street Journal's March 3, 2009 article "The Obama Economy" claims the drop in the Dow Jones Industrial Average (the Dow) is evidence of the failure of the new president's economic policies:

As the Dow keeps dropping, the President is running out of people to blame.

As 2009 opened, three weeks before Barack Obama took office, the Dow Jones Industrial Average closed at 9034 on January 2, its highest level since the autumn panic. Yesterday the Dow fell another 4.24% to 6763, for an overall decline of 25% in two months and to its lowest level since 1997. The dismaying message here is that President Obama's policies have become part of the economy's problem.

Americans have welcomed the Obama era in the same spirit of hope the President campaigned on. But after five weeks in office, it's become clear that Mr. Obama's policies are slowing, if not stopping, what would otherwise be the normal process of economic recovery. From punishing business to squandering scarce national public resources, Team Obama is creating more uncertainty and less confidence -- and thus a longer period of recession or subpar growth.

The Democrats who now run Washington don't want to hear this, because they benefit from blaming all bad economic news on President Bush. And Mr. Obama has inherited an unusual recession deepened by credit problems, both of which will take time to climb out of. But it's also true that the economy has fallen far enough, and long enough, that much of the excess that led to recession is being worked off. Already 15 months old, the current recession will soon match the average length -- and average job loss -- of the last three postwar downturns. What goes down will come up -- unless destructive policies interfere with the sources of potential recovery.

And those sources have been forming for some time. The prices of oil and other commodities have fallen by two-thirds since their 2008 summer peak, which has the effect of a major tax cut. The world is awash in liquidity, thanks to monetary ease by the Federal Reserve and other central banks. Monetary policy operates with a lag, but last year's easing will eventually stir economic activity.

Housing prices have fallen 27% from their Case-Shiller peak, or some two-thirds of the way back to their historical trend. While still high, credit spreads are far from their peaks during the panic, and corporate borrowers are again able to tap the credit markets. As equities were signaling with their late 2008 rally and January top, growth should under normal circumstances begin to appear in the second half of this year.

So what has happened in the last two months? The economy has received no great new outside shock. Exchange rates and other prices have been stable, and there are no security crises of note. The reality of a sharp recession has been known and built into stock prices since last year's fourth quarter.

What is new is the unveiling of Mr. Obama's agenda and his approach to governance. Every new President has a finite stock of capital -- financial and political -- to deploy, and amid recession Mr. Obama has more than most. But one negative revelation has been the way he has chosen to spend his scarce resources on income transfers rather than growth promotion. Most of his "stimulus" spending was devoted to social programs, rather than public works, and nearly all of the tax cuts were devoted to income maintenance rather than to improving incentives to work or invest.

His Treasury has been making a similar mistake with its financial bailout plans. The banking system needs to work through its losses, and one necessary use of public capital is to assist in burning down those bad assets as fast as possible. Yet most of Team Obama's ministrations so far have gone toward triage and life support, rather than repair and recovery.

AIG yesterday received its fourth "rescue," including $70 billion in Troubled Asset Relief Program cash, without any clear business direction. (See here.) Citigroup's restructuring last week added not a dollar of new capital, and also no clear direction. Perhaps the imminent Treasury "stress tests" will clear the decks, but until they do the banks are all living in fear of becoming the next AIG. All of this squanders public money that could better go toward burning down bank debt.

The market has notably plunged since Mr. Obama introduced his budget last week, and that should be no surprise. The document was a declaration of hostility toward capitalists across the economy. Health-care stocks have dived on fears of new government mandates and price controls. Private lenders to students have been told they're no longer wanted. Anyone who uses carbon energy has been warned to expect a huge tax increase from cap and trade. And every risk-taker and investor now knows that another tax increase will slam the economy in 2011, unless Mr. Obama lets Speaker Nancy Pelosi impose one even earlier.

Meanwhile, Congress demands more bank lending even as it assails lenders and threatens to let judges rewrite mortgage contracts. The powers in Congress -- unrebuked by Mr. Obama -- are ridiculing and punishing the very capitalists who are essential to a sustainable recovery. The result has been a capital strike, and the return of the fear from last year that we could face a far deeper downturn. This is no way to nurture a wounded economy back to health.

Listening to Mr. Obama and his chief of staff, Rahm Emanuel, on the weekend, we couldn't help but wonder if they appreciate any of this. They seem preoccupied with going to the barricades against Republicans who wield little power, or picking a fight with Rush Limbaugh, as if this is the kind of economic leadership Americans want.

Perhaps they're reading the polls and figure they have two or three years before voters stop blaming Republicans and Mr. Bush for the economy. Even if that's right in the long run, in the meantime their assault on business and investors is delaying a recovery and ensuring that the expansion will be weaker than it should be when it finally does arrive.

There are two flaws in this critique of Obama, which is coming from someone whom I presume would be criticizing him regardless of the performance of the stock market or the economy. The editorial is yet another example of the post hoc ergo propter hoc flaw of logic that is all too common in political and economic discourse. For the sake of expedience, allow me to quote the Wikipedia entry:

Post hoc ergo propter hoc, Latin for "after this, therefore because (on account) of this", is a logical fallacy (of the questionable cause variety) which states, "Since that event followed this one, that event must have been caused by this one." It is often shortened to simply post hoc and is also sometimes referred to as false cause, coincidental correlation or correlation not causation. It is subtly different from the fallacy cum hoc ergo propter hoc, in which the chronological ordering of a correlation is insignificant.Post hoc is a particularly tempting error because temporal sequence appears to be integral to causality. The fallacy lies in coming to a conclusion based solely on the order of events, rather than taking into account other factors that might rule out the connection. Most familiarly, many superstitious beliefs and magical thinking arise from this fallacy.

The form of the post hoc fallacy can be expressed as follows:A occurred, then B occurred.Therefore, A caused B.When B is undesirable, this pattern is often extended in reverse: Avoiding A will prevent B.

From Attacking Faulty Reasoning by T. Edward Damer:[1]“I can't help but think that you are the cause of this problem; we never had any problem with the furnace until you moved into the apartment." The manager of the apartment house, on no stated grounds other than the temporal priority of the new tenant's occupancy, has assumed that the tenant's presence has some causal relationship to the furnace's becoming faulty.”From With Good Reason by S. Morris Engel:[2]“More and more young people are attending high schools and colleges today than ever before. Yet there is more juvenile delinquency and more alienation among the young. This makes it clear that these young people are being corrupted by their education.

The decline of stock markets since Obama took office is not proof that his policies caused the decline nor that his policies are not the appropriate ones to improve the economy. The Dow Jones Industrial Average (DJIA) closed at 14,164.53 on October 9, 2007. On Election Day, November 4, 2008, the DJIA closed at 9,625.28. On January 20, 2009, the day of President Obama’s inauguration, the DJIA closed at 7,949.09. The stock markets were in decline long before Obama was elected or took office. The decline in the Dow since Obama became President is (7949 – 6763)/7949 = 0.149 or about 15%. The author picked an arbitrary date in January to imply a bigger decline. The decline in the Dow before Obama became President was (14164 – 7949)/14164 = .438 or about 44%. So if one wanted to usepost hoc ergo propter hoc (and remember one shouldn’t), a more reasonable conclusion is that the last 15 months of President Bush’s policies were much more damaging to Wall Street than Obama’s leadership has been.

Another flaw in this editorial is the presumption that whatever is good for stock markets is good for the economy. I agree that health-care stocks have declined because of Obama’s plans to save taxpayers money by reining in rapidly rising medical costs. But that does not prove that Obama’s policies are detrimental to the economy as a whole. Consider the opposite. If Obama announced that he would give trillion dollar gifts to all the corporations in the Dow Jones Industrial Average for no use other than to make them more profitable, the stocks of the benefitting companies would undoubtedly rise. But such a policy would add tremendously to the public debt burden of future generations without doing anything to increase the productivity of the economy or improve its long-term health. It is a mistake to assume that anything that benefits the wealthy or business interests (such as tax cuts and deregulation) is necessarily good for the economy. Some increases or decreases in taxes and government regulation of business may be beneficial to society as a whole. Others are not.

The author is critical of the income transfers in the stimulus package, preferring spending on public works. But the fundamental cause of this recession is insufficient overall spending on newly produced goods and services. The logic behind the income transfers is that they are a quick way to inject purchasing power into the hands of those most likely to spend. The biggest downside of income transfers is that the money might not be spent on newly made U.S. products. It could be used to pay down credit card debt or to buy foreign-made products, such as the many Chinese goods at Wal-Mart. If the government spends the money directly, such as on infrastructure projects, it can ensure the money goes to U.S. companies with American workers. And there is a lasting benefit from public works spending because the new highways, repaired bridges, and more energy efficient government buildings will continue to provide benefits for many years to come. The largest downside of public works spending is that these projects can take a long time to complete and the economy needs the increased spending immediately. Indeed, the best criticism of the stimulus package is that by the time some of its spending occurs, the recession might be over. (Then again, it might not.)

The criticism that the tax cuts are “devoted to income maintenance rather than to improving incentives to work or invest,” is a gilded way to assert that they should have been given to rich people and wealthy corporations rather than to low and middle-income Americans. By preserving incomes with tax reductions, the government is trying to maintain the purchasing power of the overall economy and prevent the recession from worsening. Tax policy can be used to alter society’s behavior, such as to encourage research and development or investment in physical capital. But those effects kick in much later than the immediate impact of income maintenance. And many of the tax cuts advocated by the rich are not structured to have targeted benefits to the economy. And I have always had difficulty with the theoretical argument that tax cuts increase the incentive to work. Everyone I know with a 9 to 5 job works 40 hours per week regardless of which tax bracket they are in. I have never had anyone tell me he or she works more or less because of changes in tax rates.

Anyone who has taken a class from me should know I am a huge advocate of markets and capitalism. But it is not a blind or ideological devotion. Capitalism and the markets it creates have a potentially destructive aspect. Unregulated markets can cause massive damage to society. (In the absence of government regulation, the market system allowed so much pollution into the environment that in 1969 the Cuyahoga River in Cleveland, Ohio literally caught on fire.) The important question is the appropriate degree of regulation. In a capitalist system, banks, like other profit-seeking businesses, should be allowed to fail. Yet, banks play a much different role in our economy than other businesses. The ability to borrow money does facilitate the overall spending that maintains our economy. And it is the inability to borrow and a lack of confidence in the financial sector that are critical components of our current economic troubles. Most financial experts believe failing to prop up these financial institutions would be devastating to our economy. Indeed, a common criticism of the handling of the financial crisis by President George W. Bush’s Secretary of the Treasury, Hank Paulson, is that he allowed the Lehman Brothers financial services company to go bankrupt, worsening the meltdown. In the absence of sufficient government regulation, banks became too large, too intertwined, and were allowed to engage in activities with too much risk. I believe the biggest mistake was to allow individual banks to become “too big to fail.” If government regulation had prevented much of the consolidation in the banking industry and had maintained a financial system with numerous smaller banks, it would be much easier to forego bailouts and let the worst ones fail.

It seems that even the tooth fairy business is being affected by the recession.

When today's kids put baby teeth under their pillows, they can expect on average $1.88 the next morning, according to a poll of 744 parents. That's down from $2.09 last year.

Although kids may be feeling the economic hit, they are still faring better than their parents and other adults invested in the stock market.

"Compared to the tooth fairy's 10% decrease, the Dow Jones decreased 32% over the same measurement period and global indices performed even worse," Dani Fjelstad, chief financial officer for DeCare Dental, says in a news release.

DeCare, a dental benefits management group, and Securian Dental, which runs dental plans, have been polling commercially insured members about the tooth fairy for more than a decade.

The tooth fairy has not consistently tracked with the Dow. For instance, after the dot-com bust in 2001 and 2002, the Dow declined but the tooth fairy increased her payouts.

This year's decline appears to be a result of more parents -- er, tooth fairies -- paying $1 per tooth and fewer paying $5 per tooth. Tooth fairy payouts range from 5 cents per tooth to $40 per tooth.

Sunday, March 1, 2009

In the March 1, 2009 New York Times article "The Economic Cost of War, James Glanz provides a range of estimates of the future U.S. costs of the wars in Iraq and Afghanistan.

Strike up the John Philip Sousa and throw confetti from the windows. The troops will be coming home from Iraq, President Obama announced on Friday, and if the mood was not quite as giddy as it was during a few of those triumphant marches down Broadway, there was at least the hint of a similar hope that an end of the war could help set the stage for a new era of prosperity and opportunity.

President Obama’s soaring speech on Friday announcing the drawdown and eventual pullout of troops from Iraq, framed by martial music and the cheering of an audience of Marines when he gave the timetable, could not help but be seen partly in an economic frame of reference: The war has cost an estimated $860 billion; Mr. Obama, as a candidate last year, repeatedly criticized such spending overseas during a downturn; and he had just unveiled his 10-year budget plan the day before.

The Iraq war has been criticized on many fronts, including whether it has really made the world safer for the United States. But with the economy in crisis, some of the sharpest doubts being expressed about it concern whether the money it siphoned from the Treasury helped set the terms for that crisis.

At the same time, history suggests that anticipation of an end to the war might help lift the mood of consumers and investors whose fears now deepen the economic problem.

Perhaps that is why on Friday, it was more than tempting to dredge up old images of kisses in Times Square in 1945 or Germans tearing down the Berlin Wall — and the long surges of prosperity that soon enough followed those euphoric moments, after the ends of World War II and the cold war.

But hold that parade. There are serious and possibly crippling problems with the idea that ending this war could help the cause of prosperity in any clear way. The first and most troublesome is that the continuing cost of the war is exquisitely sensitive to the precise number of troops in theater at a given time, and President Obama has said that he will remain attuned to the notoriously changeable conditions in Iraq as he carries out his plan.

Savings in Iraq will also be dampened by Afghanistan, where the plan calls for a more modest troop increase, but where the primitive transportation system can make logistics more expensive. Even if many of the Iraq war’s costs simply vanished, analysts say those savings would be too small and come too late to jolt the economy out of the crisis, though they could reduce the deficit long term, allowing a recovery to take firmer hold.

“There are a lot of red flags, basically,” said Ryan Alexander, president of the nonpartisan group Taxpayers for Common Sense, who like hundreds of other budget experts in Washington was sifting through the administration’s figures late last week. “Even in the context of the art of budgeting,” Ms. Alexander said dryly, “we have concerns that this is overoptimistic.”

The president’s defense budget does seem to get high marks across the political spectrum for its transparency in accounting for the true cost of the war; President Bush was often criticized for tucking war expenses into various line items that were hard to add up consistently. As Bob Work, a vice president at the Center for Strategic and Budgetary Assessments, put it, “People can say this budget is wrong, but it is very upfront.”

The cost of overseas conflicts, mainly in Iraq and Afghanistan, follows a fairly simple progression in the president’s budget plan: $144 billion in fiscal year 2009, $130 billion in 2010, and — in what the administration concedes are “placeholder estimates” — of $50 billion for 2011 and beyond.

Even though Mr. Obama pledged in his speech to end all combat operations in Iraq by August 2010 and have all American troops out by the end of 2011, the fairly modest dropoff in cost in the first two years is unsurprising, said Winslow Wheeler of the Center for Defense Information, a nonprofit group often critical of military spending; after all, the United States will be carrying out a corresponding increase in Afghanistan.

Beyond that, Mr. Wheeler said, the neat projections may not work out if events cause the American military to undertake more operations than expected or to keep extra troops in Iraq. The budget estimates “are a perfectly reasonable stab at it, but who knows?” he said.

Studies by two research arms of Congress reveal how much the cost depends on the timing for withdrawal. In October, the Congressional Research Service estimated that in 2006 (the latest available figures), it cost $390,000 a year to sustain each American trooper overseas. Clearly, delaying withdrawals would quickly run the tab up.

That report was followed in January by one from the Congressional Budget Office estimating how much the Iraq and Afghanistan conflicts would cost from 2010 through 2019 under two assumptions. In one, the number of troops deployed in the two countries draws down fairly quickly, to about 30,000 by 2011. In the other, levels drop to 75,000 by 2013. Both cases represent a huge reduction from the roughly 180,000 troops there now. But the difference in the cost is breathtaking: the office estimates that Congress would have to appropriate $388 billion for the case of a quick withdrawal and more than double, $867 billion, for the slower one.

Because of the huge range of possible costs, and because the logistics of withdrawal are complicated and expensive, “the basic elements of that estimate are still unresolved,” said John M. Spratt Jr., a South Carolina Democrat who is the House Budget Committee chairman and a House Armed Services Committee member.

“I have a sneaking suspicion that the near-term costs are going to outweigh the near-term savings,” said Mr. Spratt, in remarks on Friday at the Progressive Policy Institute in Washington.

Beyond all those numbers, the assertion that a war’s end has had a direct economic effect in lifting the United States out of its fiscal doldrums in the past becomes weaker the more it is analyzed, said Robert Higgs, a senior fellow in political economy at the Independent Institute in Oakland, Calif., and the author of “Depression, War and Cold War” (2006). An economic blooming, Mr. Higgs said, often is due as much to an outburst of confidence and optimism with the end of hostilities as to any particular element of industrial or economic rearrangement.

For example, part of the revival after World War II, Mr. Higgs said, can be attributed to a change in the psychology of private investors; their distrust of New Deal policies began to melt as President Roosevelt drew on wealthy businessmen to run his war effort, and then President Truman signaled that he was warmer to free-market policies than the administration of the late 1930s had been.

“It’s more complicated than the war got us out of the Depression, the way most people think it did,” Mr. Higgs said.

Simple confidence was again a factor in the economic expansion in the decade after the end of the cold war, said Paul Poast, a political scientist and author of “The Economics of War” (2006). Technological contributions to the economy like the Internet, which was developed by cold war researchers, certainly helped the expansion, Mr. Poast said. But something less definable — an overall sense that history had taken a turn for the better — was at least as powerful, he said.

“When you take away the threat of nuclear annihilation that helps things,” Mr. Poast said.

Which brings us back to that parade. President Obama may find it hard to keep the withdrawal to a prescribed timetable, and even if he can, the savings may be a drop in the bucket economically. But if he keeps the bands playing and strikes the right note in his speeches, he just may have a chance to persuade Americans that the end of a long war means better times are on the way.

History shows that if he persuades enough people, those times could actually happen. Send the marching band up Broadway.

You Want the Truth?

Comments

I welcome comments. Please keep them civil, short and to the point. Obscene, profane, abusive and off topic comments will be deleted. Repeat offenders will be blocked. Thanks for taking part — and abiding by these simple rules.

The following information is provided to help you understand the biases that may be inherent in this blog.My primary U.S. economic policy concern is the fiscal irresponsibility of government.The Baby Boom generation, which I am part of, has spent the past 30 years accumulating massive public debt that will be passed to our children, grandchildren, and subsequent generations.I am not opposed to the reduction or elimination of any government spending program.Yet, politicians tend to call for reduced spending in general terms and fail to publicly declare specific cuts they would make.The primary cause of the massive U.S. public debt is revenue reductions (in the form of tax cuts) without similar decreases in government spending.

I am willing to consider the expansion and addition of government programs as well.I do not mind how much or little the government provides to society as long as it is paid for.I am willing to pay higher taxes for services deemed worthy, whether they be national defense, homeland security, or income assistance to those less fortunate than I.And I am certainly willing to pay less in taxes or to deposit any government check I receive.My generation, the Baby Boomers, has been very good at cutting taxes and increasing the size of government, regardless of which political party is in power.This is a prescription for financial chaos that remains a horrible legacy for future generations.

About Me

I am a professor of economics at Jacksonville University, where I teach courses in introductory economics, comparative economic development, and globalization. I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.